Investors are taking too much risk and not thinking about investment factors when creating their portfolios, whether they are a big sovereign wealth fund or a small investor, said Michael Hunstad, head of quantitative strategies at Northern Trust Asset Management.

Hunstad said he knows this is the case because 85 percent of the clients at Northern Trust fall into this category, taking significant risks with their portfolio. But by targeting certain factors, investors not only can lower their overall risk, but also boost returns, he said.

He spoke at the Wealth Advisor Forum Monday in Chicago.

Hunstad said while everyone invests in factors in some way—investors are exposed to factors just by using the Standard & Poor’s 500 stock index—they’re not always doing so actively or advantageously. Investors need to think about using factors by considering risks and how to be compensated for that risk, he said.

“Factors add another layer of granularity and allow you to express your tactical and strategic views. Our most sophisticated investors are using them as building blocks to get the results they want,” he said.

The factors he looks at are classic, academically studied factors: high quality, value, low volatility, dividend-payers, size and momentum.

He said most portfolios include factors only passively, without an active strategy. Many portfolios are built keeping a balance of beta, or equity-risk premium, and alpha, or stock-picking ability. Without using factors, investors are missing out on greater potential excess return, he said.

He cited a 1997 study by Mark Carhart of University of Chicago that looked at mutual fund performance over 30 years. The research found that of the mutual funds that outperformed, on average, 6.6 percent of the return was from factors, while minus 1.56 percent was from stock-picking ability, for a net return of 4.94 percent.

When financial advisors start to use factors, they need to be intentional about how they are using them, he said. Hunstad gave two examples of using factors in asset allocation with a tactical approach. When advisors look at their macroeconomic views, such as their views on growth, inflation, monetary policy or other economic issues, they will express those views by investing in equities, debt, real estate, etc. To add factors, consider which factors do well in the expected environment, he said.

Each scenario offers "a variety of factors to be used as granular levers to adjust the outcome,” he said.

For advisors who expect relatively good economic growth, say in the 2.5 percent range, with tame inflation, they would likely invest in equities, he said. The factors to use would be to invest in high-quality, low volatility stocks. Adding these factors helps to reduce overall portfolio risk, he said, especially for advisors who have clients with reservations about being in the equity markets. 

“This is the number one thing we’re doing now. We’re increasing or maintaining equity exposure, but decreasing the risk,” Hunstad said.

For advisors who have concerns about trade policy, they may seek out small-cap stocks since these have less exposure to trade wars than large caps. That expresses the size factor.

In a rising rate regime, Hunstad said, factors perform well. As monetary policy contracts, he said all factors give excess returns, and the best-performing factor is the quality factor. Further, factors can continue to give excess returns in a low-equity return environment. Northern Trust is expecting reduced equity returns, having lowered their forecast to just under 6 percent. In this environment, the low-volatility factor has the best performance.

To use factors strategically, he said consider the traditional risk-adjusted 60-40 portfolio spilt of 60 percent equities and 40 percent fixed income, which Northern Trusts forecasts to have a 5.9 percent return. But by adding a small mix of high quality, low volatility stocks, the risk is lowered, but the return goes to 9.1 percent. If your equity portfolio is a 50-50 mix of passive/active stocks, he said, make it one-third intentionally chosen factors, one-third active and one-third passive. In this example, the intentional factor mix is small cap and low volatility

Lastly, he said, when using factors, consider the tax implication. Some factors, like momentum, can have tax implications that might offset the alpha if they aren’t controlled, since it is a faster-moving factor.

“You want to manage them in a tax efficient format, so you’re taking strategic gains and losses,” he said.